Tuesday, August 19, 2014

It seems likely that significant capital inflows are helping prop up asset valuations in the U.S.

Nobody really believes the official narrative that the "recovery" is powering the remarkable strength of U.S. stocks, bonds and real estate. The real Main Street economy is quite obviously struggling, outside the energy and Federal government sectors, and so many see the Federal Reserve's free money for financiers (a.k.a. quantitative easing) bond and mortgage-buying programs as the real reason bond yields have declined and stocks have soared.

This view has the strong merit of relying on the basics of supply and demand: if the supply of nearly free money expands while the quantity of stocks, bonds and real estate shrink, remain stable or expand at lower rates than nearly free money, the flood of liquidity will push the price of assets higher.

The Fed's suppression of interest rates has generated another powerful incentive to buy assets that generate some sort of yield: with safe Treasuries yielding so little, "risk-on" assets like stocks and junk bonds have soared due to strong demand.

But the notion that the Fed is the single cause of U.S. markets' strength doesn't quite explain why the Fed's massive reduction in QE from $85 billion/month to $25 billion/month hasn't sent markets dependent on the Federal Reserve's free money for financiers into a tailspin.

For an example of what the Fed's tapering should do if it is indeed the dominant causative factor, we need only look at what happened to peripheral capital markets in 2013 when the Fed started tapering: they tanked as speculative inflows dried up.

This leads us to wonder if capital inflows into the U.S. aren't a largely overlooked driver of rising U.S. markets. Capital inflows are certainly a factor in the buoyancy of U.S. real estate, as various estimates peg recent Chinese purchases of U.S. housing at $22 billion--and this is only a snapshot of a much larger flow of capital flowing into the U.S. real estate market from Russia, the mideast and Asia.

While capital inflows into U.S. stocks are difficult to monitor, U.S. stocks provide the same relative safety to global capital as U.S. real estate: a strong rule of law, liquid markets, and a lower risk of bail-ins, confiscations and prison sentences for ill-gotten gains reaped overseas.

Please note the phrase relative safety: there are no absolutes when it comes to central banks and states, but as conditions deteriorate elsewhere, the flexibility and wealth of the U.S. provides a relative security that may not match Switzerland, but it offers other benefits, for example, a broad and deep range of assets for sale.

For years, observers have seen the massive Treasury holdings of China as a potential financial weapon: were China to dump a trillion dollars of Treasuries, that would crush the global market for U.S. bonds. (I have always held the Fed could issue a fresh $1 trillion and buy the lot in one fell swoop.)

The discussion of major foreign holders of Treasury Securities, i.e. foreign states and central banks, often overlooks one key driver of this trade: states seeking to weaken their own currency to boost exports sell their own currency and buy U.S. dollars. This increases the supply of their own currency, pushing the value lower, while the increased demand for dollars pushes the value of USD higher.

In terms of currency pairs, this weakens the currency of the buyer of Treasuries in relation to the dollar.

This is the root of the beggar thy neighbor approach to weakening one's currency at the expense of one's trading partners. But since every central bank that issues new credit-money effectively weakens its currency, this game has limits, as every major central bank has pursued easy-money policies such as quantitative easing.

In other words, major holders of U.S. Treasuries such as China and Japan have an over-riding incentive to keep buying Treasuries: keeping their currency either stable or weak vis-a-vis the U.S. dollar.

Private capital could well be selling Treasuries in order to buy "risk-on" assets such as corporate bonds, stocks or real estate, but there are other reasons for managers of private foreign capital to keep cash in U.S. Treasuries: the market is very liquid, and ownership of Treasuries is also a bet that the dollar will strengthen in relation to other currencies.

Given the increase in geopolitical tensions and other conditions--for example, Fed tapering--this is not a bad bet. Consider the trading range of the U.S. dollar since the 2008 global financial meltdown: the USD has drifted in a relatively narrow band.

Put these various factors together and it seems likely that significant capital inflows are helping prop up asset valuations in the U.S.

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